Category Archives: Self-Directed Roth IRA

Self-Directed Roth IRA, Self-Directed Traditional IRAs

Wealth Building Options for Your IRA

Many people would like to buy real estate in their IRAs but have a mistaken belief that they do not have enough money to do so.  Nothing could be further from the truth!  You may invest in real estate with your IRA without a lot of money in several ways, including partnering with other IRAs or non-IRA money, buying property with debt, or by using one of the most powerful and under utilized tools in real estate investing today – the option.

In this article we will focus on some option basics.  First, what is an option?  Once consideration for the option is paid, it is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time.  The buyer has the right but not the obligation to buy.

You might wonder why an owner would agree to tie up his property with an option.  Advantages to a property owner include:  1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money, an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.

Do the paperwork right!  Options are extremely powerful and very easy to mess up.  Be very specific, clear and complete about all the details.  Remember, with options, you have to negotiate for both the option and for the purchase of the property. With a well written option, the following must be, as my old law professor was fond of saying, “patently obvious to the most casual observer”:

a)         Who is granting the option?  Does it include heirs, successors and assigns?
b)         Who is receiving the option?  Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?
c)         What property is being optioned?  Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.
d)         What is the consideration for the option?  Remember, there must be some consideration for the option in the form of money, services or other obligations.
e)         How is the option exercised by the buyer?  This is one of the easiest things to mess up in an option.  If the procedure is not clear for exercising the option, it is an invitation to litigation!
f)          What will be the purchase price of the property if the option is exercised?
g)         How will the purchase price be paid when the option is exercised?  Will it be for cash?  Seller financing?  Subject to the owner’s existing mortgage?
h)         Will the option consideration be credited to the option price or not?
i)          When can the option be exercised?  For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?
j)          When will the option expire, and under what circumstances?  The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.
k)         When it comes time to close, what are each party’s obligations?  For example, who pays for title insurance, closing costs, etc?  Are taxes prorated?

So what forms do you use?  The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes.  They are simply too flexible.  You must decide on a specific use for the option and then, as Shakespeare said, “Get thee to a lawyer!” (Okay, it was “Get thee to a nunnery” but I like it better as revised!).

When you have negotiated an option agreement for your IRA, you have several choices.  First, you can let the option expire on its own terms.  Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option.

Another choice is that your IRA could exercise the option and buy the property.  Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase.  Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT).  This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.

A third choice which is often employed in the context of self directed retirement accounts is to assign your option to a third party for a fee.  Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner.  This is a great technique for building a small IRA into a large IRA quickly.  I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500.  In under 1 month the account made a profit of 8,400%, and all parties were happy with the deal!  The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.

A fourth choice that sometimes is overlooked is the ability to release the option back to the property owner for a cancellation fee.  In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work.  Suppose you want to offer the seller what he would consider to be a ridiculously low offer.  When the seller balks, you say “I’ll tell you what.  You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days.  If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.”  Either way, your IRA wins!

The creative use of options can make your IRA grow astronomically if done correctly.  In future articles I will be discussing different types of option strategies.

Health Savings Accounts, Self-Directed 401(k), Self-Directed Roth IRA, Self-Directed Traditional IRAs

How Do I Invest Thee? Let Me Count the Ways!

Many people find it very easy to see the benefits of self-directing their Roth and Traditional IRAs, SEP IRAs, SIMPLE IRAs, Individual 401(k)s, Coverdell Education Savings Accounts (ESAs) and Health Savings Accounts (HSAs) into something other than the same old boring stocks, bonds, annuities and mutual funds.  The central idea of a self-directed IRA is that it gives you total control of your retirement assets.  With a self-directed account you can invest your IRA funds in whatever you know best.

When I spoke recently at John Schaub’s Real Estate All Stars conference in Las Vegas, Nevada, I outlined some of the top strategies our clients have actually used to build their retirement wealth.  A brief description of these strategies is included in this article.  This shows the tremendous flexibility of investing through a self-directed account.

Strategy #1 – Purchasing Rental Real Estate for Cash.  Even the IRS acknowledges on its website that real estate is an acceptable investment for an IRA.  In answering the question “Are there any restrictions on the things I can invest my IRA in?” the IRS includes in its response that “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”  One of our clients purchased a 10 unit apartment complex for $330,000 cash.  In April, 2008 his total rent collection was $5,235.  Even after payment of taxes and insurance, his cash on cash return is excellent, and the client believes that the value of the property will increase significantly over time.  A discussion of the relative benefits and disadvantages of owning real estate directly in an IRA is beyond the scope of this article, but for those who know how to successfully invest in real estate it is great to know that real estate is an option for your self-directed account.

Strategy #2 – Purchase, Rehab and Resale of Real Estate.  In this case study, our client decided not to hold onto the real estate purchased with his IRA.  The client received a phone call one evening from an elderly gentleman who said he needed to sell his home quickly because he wanted to move to Dallas with his son.  After a quick phone conversation, it was clear that the price the seller wanted was a bargain even considering the needed repairs.  Our client dropped what he was doing and immediately headed over to the seller’s house with a contract.  The buyer on the contract was our client’s IRA, and of course the earnest money came from the IRA after the client read and approved the contract and submitted it with a buy direction letter to Quest IRA, Inc.  They agreed on a sales price of $101,000.  Approximately $30,000 was spent rehabbing the property with all funds coming from the IRA.  The property was sold 6 months later for $239,000, with a net profit after sales and holding expenses of $94,000!

Strategy #3 – Purchase and Immediate Resale of Real Estate (Flipping).  The previous two examples show the tremendous power of buying real estate for cash with a self-directed IRA.  However, both of these strategies require a significant amount of cash in your account.  How else can you invest in real estate if you have little cash?  One of our clients was able to put a commercial piece of vacant land under contract in his Roth IRA.  The sales price was $503,553.60 after acreage adjustments.  Using his knowledge of what was attractive for a building site, our client was able to negotiate a sales price to a major home improvement store chain for $650,000.  On the day of closing Quest, IRA Inc. received two sets of documents, one for the purchase of the property for $503,553.60 and the other for the sale of the same property for $650,000.  After sales expenses, the IRA netted $146,281.40 from the sale with only the earnest money coming from the account!  A word of caution in this case is that if property is flipped inside of an IRA the IRS may consider this to be Unrelated Business Taxable Income (UBTI), causing the IRA (not the IRA owner) to owe some taxes on the gain.  Even if taxes had to be paid, it is hard to argue that this transaction was not beneficial to the IRA and ultimately the client!  It should also be noted that in this situation everyone involved in the transaction was aware of what everyone else was doing, so there was no “under the table” dealings.

Strategy #4 – Assignments and Options – Getting Paid NOT to Buy!  Another favorite strategy for building tremendous wealth without a significant amount of cash is the use of options and assignments.  One of our clients put a property under contract in his daughter’s Coverdell Education Savings Account for $100.  The sales price was a total of $5,500 because the house had burned down.  The seller was just getting rid of the property for its lot value since he had already received a settlement from the insurance company and had purchased another house.  Our client then used his contacts to find a person who specialized in rehabbing burned out houses.  The new buyer was willing to purchase the property for $14,000 cash.  At closing one month after the contract was signed, the seller received his $5,500 and the Coverdell ESA received an assignment fee of $8,500 right on the settlement statement.  That is an astounding 8,400% return on the $100 investment in only 30 days!  Even better, our client was then able to take a TAX FREE distribution from the account of $3,300 to pay for his 10 year old daughter’s private school tuition.  In a similar transaction, another client’s Roth IRA recently received an assignment fee of $21,000 plus reimbursement of earnest money for a contract.

Strategy #5 – Using the Power of Debt Leveraging.  One of my favorite true stories of building wealth in a Roth IRA involves purchasing property subject to a debt.  If an IRA owns debt-financed property either directly or indirectly through a non-taxed entity such as a partnership or LLC taxed as a partnership, profits from that investment are taxable to the same extent there is debt on the property.  One of our clients used her knowledge of real estate investing and what she learned from a free Quest IRA, Inc. educational seminar to tremendously boost her retirement savings.  After noticing a large house in downtown Houston which was in bad shape but in a great location, our client tracked down the owner in California who was being sued for approximately $97,000 in delinquent taxes on the property.  She negotiated a deal with the seller for her Roth IRA to purchase the property for $75 cash subject to the delinquent taxes.  With closing costs her Roth IRA’s total cash in the transaction was only around $3,000.  Within 4 months she was able to sell the property for a profit to her Roth IRA of $43,500!  Because the property had debt on it and because her Roth IRA sold the property for a short term capital gain, the taxes on the profit were approximately $13,500.  Still, using the power of debt leveraging her Roth IRA was able to achieve a 1,000% return in less than 4 months even after paying Uncle Sam his share of the profits!

Strategy #6 – Hard Money Lending.  Another excellent strategy for building your retirement wealth is through lending.  Loans from IRAs can be made secured by real estate, mobile homes or anything else.  Some people even choose to loan money from their IRAs on an unsecured basis.  As long as the borrower is not a disqualified person to the lending IRA, almost any terms agreed to by the parties are acceptable.  In many states there are limits to the amount of interest that can be charged, and loans must be properly documented, but IRA law does not impose any limits other than the prohibited transaction rules.  For those wanting to avoid the direct ownership of real estate within their IRA, a loan with an equity participation agreement is often used.  Several of my own self-directed accounts combined together recently to make a $25,000, 7 1/2 year, 12% first lien loan against real estate with 6% in points up front.  True, this is not exactly setting the world on fire as far as return on investment goes, but I was very pleased with a safe return on a relatively small amount of cash.  If I get to foreclose on the collateral my accounts should be able to make a substantial profit, since the land securing the loan was appraised at $45,000.  At my office we routinely see hard money loans secured by first liens against real estate with interest at 12%-18% for terms ranging from 3 months to 3 years.

Strategy #7 – Private Placements.  Many of the best opportunities for passive growth of IRAs include the purchase of private limited partnership shares, LLC membership units and private stock which does not trade on the stock market.  Let me give you two examples from my own retirement account investments.  In one case my 401(k) plan invested in a limited partnership which purchased a shopping center in northern Louisiana.  The initial investment was $50,000, and in a little over 2 years the partnership has returned $59,321.  The plan’s remaining equity is estimated as of 12/31/2007 at $31,598 and the return on investment will be around 82%.  Even though the property is debt-financed the taxes on the profit have been almost nothing since the plan has taken advantage of depreciation and all of the normal deductions.  Once your IRA or other plan owes taxes due to debt financing, it gets to deduct a pro rata share of all normal expenses.  Another of my 401(k) plan investments is bank stock of a community bank in Houston, Texas.  The initial shares were sold at $10 per share in February, 2007.  The book value after less than 1 year of operations was $11 per share, and shares have recently been selling to other private investors for as much as $14.25 per share!  That is a great return for a completely passive investment, and when the bank finally sells the shares are expected to sell for well above these amounts.

Strategy #8 – Owning a Business in Your IRA.  One of the most innovative strategies we have seen is the ownership of a business by an IRA.  Although neither you nor any other disqualified person may provide services to or get paid for working at a business owned by your IRA or other self-directed account, this does not mean that your IRA cannot own a business.  Some companies do market the ability for you to start a C corporation, adopt a 401(k) plan, roll your IRA into the plan, and purchase “qualifying employer securities,” but this is different than an IRA owning a business directly.  For example, my Health Savings Account invested $500 for 100% of the shares of a corporation which arranges for hard money loans to investors.  The company is fully licensed as a Texas mortgage broker.  The structure of the company is a C corporation.  Since being a mortgage broker is a business operation, profits from the venture would have been taxable to my HSA if the entity formed to own the business was not taxable itself, and the tax rates for trusts such as IRAs and HSAs are much higher than for corporations.  While normally dividends from C corporations are taxable a second time to the shareholder, dividends paid to an IRA or HSA are tax free as investment income.  The corporation is run by non-disqualified persons who handle the due diligence on the loans and the legal work, as well as by a licensed Texas mortgage broker who sponsors the corporation’s mortgage broker license.

Strategy #9 – Using OPI (Other People’s IRAs) to Make Money Now.  Even if you have not found the investment strategy of your dreams among the strategies discussed in this article, or if you have no IRA or if you are more focused on making money now to live on, your time spent reading this article can still be of great use to you.  For each of the above strategies I have focused on the possibility that your IRA could be the investor.  But what if you are the recipient of the IRA’s investment money?  Are you a real estate investor having a hard time finding funding for your transactions?  If you know people with self-directed IRAs or people who would move their money to a self-directed account, you can borrow their IRA money and virtually create your own private bank!  You can also partner with OPI where the IRA puts up the money and you share in the equity for finding the deal and managing the project.  Simply by explaining to people that they can own real estate in their IRAs you may be able to sell more property, either as a real estate broker or as the seller.  You can even provide financing for your sales by having OPI make loans to your buyers.  Finally, OPI can be a great way to raise capital for your business venture, although you must be aware of and comply with all securities laws.  One bank I know of told me that 42% of their initial capital came from retirement accounts!  Although you cannot use your own retirement account to benefit yourself at present unless you are over age 59 1/2, these are just some of the ways you can use OPI to make money for yourself right now.  A good network is the key to your success.

What I have discussed in this article have been some of the more common investment strategies actually used by our clients.  The only restrictions contained in the Internal Revenue Code are that IRAs cannot invest in life insurance contracts or collectibles.  Almost any other investment that can be documented can be held in a self-directed IRA.  As long as you follow the rules and do not invest in prohibited investments, your only real limitation is your imagination!